This invention relates to a system and method for improving the speed of calculating the price of complex financial instruments, such as Collateralized Debt Obligations.
The market for structured financial products, such as Collateralized Bond and Debt Obligations (CBOs and CDOs) has grown enormously in recent years. A CDO is a portfolio of debt instruments, typically corporate bonds, against which notes are issued. The notes have varying cash flow priority and credit quality depending on the subordination level of each note (i.e. tranche). The equity tranche provides the lowest subordination level, the mezzanine tranche reflects an intermediate level of subordination, and the senior tranche provides the highest level of subordination. Losses that occur when there is a credit event, such as a default of one of the debt instruments in the portfolio, are typically absorbed by the lowest tranche first. As such, notes from the equity tranche present a high level of risk and a large coupon, whereas notes from the senior tranche present a low level of risk and a small coupon. These structured financial products enable asset managers to diversify, create liquidity, and manage risk. As the market grows for these financial products, the need for accurate real-time pricing increases.
The prior art method for pricing structured financial products such as CDOs is slow. The typical approach includes determining the probable default times for each of the debt instruments in the CDO using simulation techniques such as those taught by Duffie-Singleton. (See Simulating Correlated Defaults, Darrel Duffie and Kenneth Singleton, September, 1999.) The probable default times may be represented as default time vectors. The cash flow associated with each default time vector is calculated, and a tentative price for the CDO is determined based on the cash flows and interest generated by the instruments comprising the CDO. The final price of the CDO is then determined using a Monte Carlo simulation in which the steps of determining a default time vector and the resulting cash flows based thereon is typically repeated up to 50,000 times for a given CDO. This process of pricing CDOs is very slow however, and therefore not suitable for pricing CDOs in a real-time market environment.
Accordingly, it is desirable to provide a system and method for calculating the price of complex products, such as CDOs, at a faster speed.